Exchanges vs. brokerages: the power struggle at the heart of high frequency trading

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High frequency trading has become the poster child for a slew of issues generated by technological developments in finance. Automation that eliminated the need for specialists on the floor of the New York Stock Exchange and eliminated arbitrage opportunities for brokers and day traders has swept through the world’s financial centers like a force of nature. Some of the most recent furor has erupted around dark pools: enigmatic, anonymous trading hubs which don’t publish bids and offers.

Dark pools allow investors to make big trades without broadcasting their positions—a boon since the very act of bidding or selling publicly would change the price of a security on an exchange. But anyone who thinks this behind-the-scenes (or “dark”) trading hasn’t been happening for ages is deluding themselves. Both market conditions and increased automation make it easier for players to make trades outside of “lit” markets, where prices of securities are published throughout the day. But in reality, automation has merely empowered threats to the old exchanges’ dominance. More than anything, the hubbub has been generated by a feud between exchanges and brokerages for fees and the first glimpse at information.

Powerful stockholders have long been able to trade while hidden from view. A 1993 New York Stock Exchange working paper described the practice (pdf), trading big “blocks” of stocks “upstairs”:

These days, a block of 10,000 shares is not a particularly large trade. For liquid stocks, an order of this size will almost certainly be brought directly to the post by a floor broker. In the case of orders which are large relative to a stock’s usual market size, however, member firms will usually explore interest “upstairs” before bringing the orders to the floor for crossing subject to the Exchange’s crossing and block positioning procedures.

Dark pools, most of which are run by brokerage firms, didn’t reinvent the wheel here. They merely took this back-room, hush-hush trading and turned it into an electronic business.

As it happens, demand for secrecy exists outside of big “block” trades, even when there’s plenty of liquidity in the markets (in other words, many traders looking to buy) very close to the best bid or offer price published by the world’s exchanges. That’s particularly the case in low-priced securities, where a single significant trade has a big effect on the price in the markets. Algorithms can sometimes interpret visible orders more quickly than they can be executed, and that cuts out some of the profits available. So if traders can’t make as much money in traditional exchanges, they’ll look for another place to do business. That’s part of the reason that traditional exchanges have been concerned by “dark pools,” which are essentially stealing away some of their business.

With the rise of dark pools, exchanges now miss out on some of the trades that happen in the market, costing them precious fees.(TABB Group)

The public exchanges complain that they are subject to more stringent regulation than dark pools, but in reality, they have their own set of hush-hush order types and secretive, subscription trading tools. Miranda Mizen of the TABB Group—which researches and collects data from both exchanges and dark pools—describes this as “dark execution,” “where there’s no pre-trade transparency…nobody knows [an order] exists prior to the trade.” These are the kinds of orders that have been most openly criticized, both by the Securities Exchange Commission and by investors, because the exchanges sell complicated, more favorable products to those customers who can pay for them.

Whether in the dreaded dark pools or in the exchanges themselves, hidden trades and orders are nothing new. “We fear what we either can’t see or don’t understand,” Mizen tells Quartz. “This is just the automated version.” For the exchanges, this is a fight for relevance and survival. Once the only players able to take advantage of upstairs or on-the-floor trades, exchanges have been duking it out with brokerages for a piece of the pie. And in times of market uncertainty and low trading volume, that battle gets all the more heated. “If you’re last in line, you’re often the lowest quality trade,” Mizen says.